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Transition from Informal Firms to Formal
What prevents informal firms from converting to formal? This study develops a self-choice model where the owners are driven by their professionalism, asset holding, landownership, and tax rates. It is found that the owner’s self-drive and efficiency parameter to convert to formality is explained by their professional skills and ownership status.
The transition of informal enterprises to the formal sector and the disproportionately large size of the informal sector has been a matter of interest for a long time. But the reasons for this still remains elusive. Informal and petty firm owners may not intend to be registered with jurisdictional tax authorities or comply with regulations. They provide goods or services of commercial nature and pay for expenses by cash with or without having a bank account. They do not pay taxes or duties to local or provincial authorities. Banerjee and Duflo (2011) suggest that informal units are set up by owners who may be surviving at near subsistence levels. Informal firms are inefficient, small, and operated by poorly endowed entrepreneurs. They suffer from livelihood risks relying on what could be limited social capital and renege on payments to workers and suppliers and escape from regulators shifting their location or time of operations over and over again during the year. These owners could be subjected to surprise or disaster raids by authorities.
De Soto (2000) suggests that informal firms are formidable employers and could become successful future entrepreneurs. The works of authors Levy (2008), Lewis (1954), and Rauch (1991) highlight that informal firms possess a skewed distribution of assets. Formal entrepreneurs participate to pay taxes and incur the compliance costs to run their business, employ labour, raise funds, and utilise the public infrastructure. Informal entrepreneurs lack the professionalism (quality) to deploy productive resources. They run smaller businesses producing low-quality products using little capital and generate very little value addition. What prevents firms from going formal? When the entrepreneur chooses to deploy capital, it requires skilled labour in conjunction with higher productivity to attain enhanced output. The question of penalty costs borne by informal owners may increase with factors specific to their business. The theories of demand-based dualism imply that growth in a nations’ population may lower the rate of decline in the informal sector. Natarajan et al (2020) shows evidence of about a 10% lower share of self-employed workers. The International Labour Organization (ILO 2014) report suggests that the 10-worker threshold is especially important because labour laws on wages and benefits are applied to units above this size. Firms can avoid being part of the organised sector in two ways: operating “under the radar” by simply not registering or by not growing.
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